Europe Economy

Euro’s struggling countries set to outperform rich neighbors, say banks

Gallo Images | the Agency Collection | Getty Images

Stocks in weaker euro zone countries like Spain and Italy look set to outperform their stronger peers this year and next, analysts say.

Stock markets in the euro zone's peripheral countries of Portugal, Spain, Italy, Ireland, Cyprus and Greece have performed strongly in 2013, boosted by waning fears of a euro zone breakup and the ultra-loose monetary policy of the European Central Bank.

(Read more: Inflation will rise but risks remain: ECB official)

By Tuesday, the Madrid stock exchange had risen 19 percent year-to-date while Italian stocks were around 16 percent higher and the Athens index had gained nearly 30 percent.

Banks forecast further strong gains, thanks to improving growth prospects, better current account balances and the diminishing risk that there could be further sovereign defaults.

Credit Suisse, which was overweight both Italy and Ireland, said the narrowing economic growth gap between weaker and "core" European countries implied a 20 percent outperformance of peripheral equities into 2014.

(Read more: Peripheral bonds: How to play Europe's recovery)

It noted that the gap between year-on-year real economic growth in core countries, France and Germany, and peripheral countries, Spain and Italy, stood at 2.4 percentage points in the second quarter of 2013, but was set to narrow to 0.9 percentage points by the end of 2014.

"Within a European portfolio, we believe investors should be overweight peripheral Europe," said the Swiss bank, in a report detailing its global cross-asset strategy on Tuesday.

Equities in 2014: What to expect

Europe's periphery was hardest hit by the 2008 credit crisis and subsequent European debt crisis, and is seen as riskier than their core counterparts because they are more likely to default on their government debt.

However, a string of positive economic reports since this summer have raised hopes the region's economic recovery is becoming entrenched. In particular, official data suggests the euro zone economy grew by 0.3 percent between the first and second quarter and 0.1 percent in the third quarter. And after several quarters of economic contraction, Spain grew by 0.1 percent in the third quarter.

Peter Oppenheimer, the chief global equity strategist at Goldman Sachs, said in a research note that the bank's peripheral euro zone stock basket was a top-performer, up 18 percent year-to-date. He forecast strong gains next year as well.

"After three years of virtual stagnation, we expect European profits to grow 14 percent in 2014, driven by an improvement in global growth and some rise in margins. This pace of growth would be slow by the standards of typical recovery phases, but it would be enough to generate a total return through 2014 of about 15 percent," he wrote.

Despite the optimism, Credit Suisse highlighted several potential red flags that could put a stopper on a further rally.

"Many economic fundamentals are still worse than in the core; in Spain, leverage, GDP (gross domestic product) and housing prices are only back to trend; Spanish and Irish banks aren't cheap; Italian exports and ULC (unit labor costs) and WEF (World Economic Forum) competitiveness rankings confirm that too little has changed," it said.

Nonetheless, U.K. bank HSBC said it was overweight Italy and Spain, as well as overweight on the euro zone overall.

"European equities have rallied since the third quarter, but we sense that many investors have only begun to dip their toes in the water. Economic growth has turned, with our economists forecasting real GDP (gross domestic product) growth of 0.8 percent in the euro zone for 2014.

"Our top-down earnings models suggest that something close to the consensus forecast of 14 percent EPS (earnings per share) growth in Europe ex-U.K. and 10 percent in the U.K. is achievable," said Garry Evans and Daniel Grosvenor of HSBC's equity research team in a report.

—By CNBC's Katy Barnato